Monday, 29 July 2013

While most international attention has focused on recent
developments in Japanese monetary policy, there are interesting developments on
the fiscal side too. A key issue is the proposal to raise the national consumption/sales tax from 5% to 10% in two stages beginning in April next year. Japanese
Prime Minister Shinzo Abe says he will wait until probably the autumn to make a
final decision, and the macroeconomic outlook will be a key factor. The
proposal has the support of Bank of Japan governor Haruhiko
Kuroda. However the more interesting question for Kuroda is how the Bank will
react to the sales tax increase.

Much of the reporting on this issue is along the familiar lines
of whether it is better to focus on reducing the government’s very high level
of debt (raise sales taxes) or ending deflation in Japan (don’t raise sales
taxes). While this debate is a familiar one, there is an additional twist with a sales tax. An anticipated
increase in sales taxes, by raising expected inflation, will - other things
being equal - provide an incentive for consumers to bring forward their
spending. Macroeconomists would describe this as a real interest rate effect,
but in simpler terms it makes sense to buy before prices go up.

This incentive effect has been observed in Japan in the past,
and in other countries. (See page 12 of this IMF report on the issue.) The UK cut VAT for just
one year in response to the recession in 2009, a measure I have described as New Keynesian countercyclical
fiscal policy, and this may have raised consumption by over 1%, in part because
consumers anticipated that prices would rise again in 2010. (The over 1% figure
comes from here,
although this
analysis is more conservative.)

However, this effect only occurs if monetary policy does not
react to the sales tax rise, and the increase in headline inflation that this
will bring. If every percentage point increase in inflation is matched by the
same increase in the nominal interest rate (and we ignore taxes), the effect
will disappear. (Prices will rise, but so will the value of my savings so I can
afford to wait.) If the Bank of Japan attempts to reverse the increase in
inflation by tightening policy still further, then we get a very undesirable
outcome.

These considerations suggest two things. First, if they take
place, increases in sales taxes should be deferred by long enough to allow any
bringing forward of spending to happen. The worst thing you can do in
current circumstances is implement an unexpected sales tax hike. Why not raise
sales taxes by 1% each year for the next five years? Those who suggest that
acting gradually ‘risks losing the credibility of financial markets’ should be
ignored. Second, the Bank of Japan should commit to ‘see through’ the impact
of sales taxes on inflation, and not tighten monetary policy in any respect
(conventional or unconventional) following the increase in inflation that
higher sales taxes will bring. It would be good if that commitment can be made publicly before the increase in sales taxes is confirmed.

Sunday, 28 July 2013

This is off the usual macro beat, so probably this point has
been made in a much clearer way by others, but it is hardly ever made in the
public debate, and I have read economists who argue the opposite. It was prompted by the UK
government’s predictable decision to kick ‘plain packaging’ of
cigarettes (example below) into the long grass. One of the arguments used against plain packaging is that
it represents yet more paternalism by the government. My general thought is
this: is banning advertising paternalistic, or is it enhancing our freedom?

A simple definition of paternalism is an action, by a person,
organisation or the state, which limits the liberty or autonomy of other people
for their own good. So we have individual freedom, interference, and crucially motivation.
Advertising is usually portrayed as just providing information so that
consumers can make informed choices. Sometimes it may do that. But advertising
is often about suggesting associations, which provide no information at all. It
is a mild form of brainwashing. Most of the time it is simply annoying.

For some, the information provided by some advertising might be
useful. For most it is not. We can try and avoid advertising if we do not want
its ‘information’, by turning the page, recording the programme and
fast-forwarding through the adverts, averting our eyes, but this requires
effort. Why should I have to make that effort? So for most people most of the
time, it is advertising that mildly interferes with our freedom. (If I wanted
to be clever, I could say that companies who advertise believe their product makes consumers better off, and therefore it is advertising that is
paternalistic. However companies advertise to increase profits, not to increase
consumer utility.)

So a government that prevents advertising can be seen as
allowing individuals to make their own unencumbered choices. It is giving us a
little more freedom and autonomy, rather than limiting it. The argument for advertising has
to be that the benefits to the few in getting useful information outweighs the
costs to the many in either avoiding it, or getting information they do not
want. It is not paternalistic to ban advertising, just as it is not
paternalistic to stop people being stalked.

That is the general point which hardly ever seems to be made.
It applies, for example, to banning food advertising aimed at children, where
the nuisance element of the advertising has to outweigh its information
provision. However the debate about ‘plain packaging’ is not about either
packaging that is plain, or the pros and cons of advertising. The Australian
version of plain packaging replaces the logo of the cigarette with a picture of
one of the health risks if you smoke these cigarettes (see below). So it is not
about banning advertising, but replacing one type of advertising with another.

Those who do not smoke and have no intention of smoking are not
forced to look at these adverts, so banning this kind of advertising would not
increase their freedom. For those who do not smoke but might smoke, and probably for those who do smoke, the
information content of the ‘plain packages’ is clearly much greater than
packages that were dominated by a logo. So this is one example where the
information content of advertising does dominate any reduction in freedom that
the advertising entails.

One final point about information. Mark Littlewood, Director
General at the Institute of Economic Affairs, says on their website that following the government’s decision: “Hopefully this will mark a turning point
against the excessive elements of the health lobby whose desire to interfere
knows no bounds.” Yes, of course, that strange desire to restrict what
companies that sell products that kill people are allowed to do. In the Notes
to Editors on that website, it says that “The IEA is a registered educational
charity and independent of all political parties.” Now I wonder
whether the IEA is funded by the tobacco companies that have lobbied
hard against plain packaging? That would be useful information, so why does
the IEA not provide it, or even advertise it?

Wednesday, 24 July 2013

Just how much should central bankers express views about fiscal
policy? One reasonable response is not at all. Yet fiscal actions can have
implications for monetary policy, so vows of silence are both difficult to
sustain, and potentially withhold important information from the public.

For example, I have recently suggested that it is almost undeniable that
fiscal austerity when interest rates are at the Zero Lower Bound (ZLB) makes it
more difficult for monetary policy to do its job. If I was a monetary policy
maker, I would want to make that clear to the public, if only to avoid getting
all the blame when things go wrong. I have praised Ben Bernanke’s recent comments to that
effect, which he reaffirmed more recently. Of course, outside
the Eurozone, it would be seen as wrong for central bankers to condemn these
policies, but it must be right for them to point out that it causes them
difficulties.

So there should not be a taboo on central bankers talking about
fiscal policy, when it influences their ability to do their job. Policy
makers at the European Central Bank (ECB) are particularly fond of talking about fiscal
policy and structural reform. Here is just one recent example, but the ECB’s
own research confirms that “the ECB communicates
intensively on fiscal policies in both positive as well as normative terms.
Other central banks more typically refer to fiscal policy when describing
foreign developments relevant to domestic macroeconomic developments, when
using fiscal policy as input to forecasts, or when referring to the use of
government debt instruments in monetary policy operations.”

So why does the ECB stand out here? One hypothesis that appears
not to work is that the ECB has been dragged into commenting on fiscal issues
by the Eurozone crisis. We could question, as Carl Whelan does (pdf), why the ECB is part of the Trioka?
Was it dragged, or did it invite itself? However, as the ECB research cited
above shows, the ECB’s unusual interest in making normative statements on
fiscal policy predate this crisis period.

One strong clue is the nature of these interventions. Bernanke
warns that excessive fiscal tightness could slow down the US recovery, and
because of the ZLB the Fed’s ability to counteract this is at
least uncertain. The ECB always urges European governments to make fiscal
policy more restrictive. That suggests that it either has a completely
different view about the macroeconomic conjuncture in the Eurozone compared to
the US (unlikely), or that it believes in expansionary austerity (see below),
or that it is concerned about something else (much more likely). The something
else which many economists would point to is fiscal dominance.

The ECB and many other European policymakers seem obsessed by
the fear that monetary policy will not be able to do its job because of
excessive budget deficits in individual Euro member states. So how reasonable
is this fear, and is the Eurozone special in this respect, so as to explain the
ECB’s unusually vocal behaviour compared to other central banks? The answer is
I believe quite clear - the ECB has less
to fear from fiscal dominance than any other central bank!

It was partly to show this that I wrote two recent posts on
budget deficits and inflation. In the first, I made the widely accepted point that
monetary policy can always neutralise the impact of higher debt on inflation by
raising interest rates, if fiscal policy makers raise taxes or cut spending
sufficiently to stabilise debt. Once you eliminate market panics through OMT,
then it is absolutely clear that all Eurozone countries are doing that. So
there is no present threat of fiscal dominance.

But imagine there was. In a second post I looked at the possibility that a fiscal
policy maker might not even attempt to stabilise debt. In that case, a conflict
between fiscal and monetary policy could emerge. Yet I argued that in any
resulting game of chicken, if the central bank was able and prepared to allow
governments to default and not monetise the deficit, it could retain control of
inflation. Now in nearly all countries the government has ultimate power, so it
could force the central bank’s hand (although at perhaps a very high political
cost). However the one exception is the ECB. The ECB is in a better position to
resist fiscal dominance than any other central bank.

So we should see much less of a concern about budget deficits
from the ECB than from other central banks, yet we actually see the opposite. I
can think of only three explanations for this apparent contradiction. The first
is that the ECB does not understand its own position. The second is that the
ECB is really concerned about the distributional effects if countries pursue
different fiscal paths. Yet if that was the case, they should be focusing on
relative fiscal positions, rather than always suggesting lower deficits are
good. The third possibility is that the ECB is using its position of authority
to pursue other economic or political goals that have nothing to do with its
mandate. The ECB is also fairly unique in its lack of accountability. Perhaps
for that reason, it feels no inhibition in being free with its opinions on
economic issues, even when they have no bearing on its ability to control
inflation.

This third explanation may also help explain the reluctance of
the ECB to act as a sovereign lender of last resort. We had two years of an
existential Euro crisis before OMT was introduced. The argument that is
generally used to explain this reluctance is the ECB’s fear of fiscal
dominance. However, as I have argued, the ECB has much less to fear on this
account than others central banks, yet other banks were quick to undertake
Quantitative Easing. As this piece reminds us, and as is noted by Peter Dorman here, pressure from the
bond market can be very useful in helping achieve certain economic and
political goals. So even though these goals have nothing to do with the ECB’s
mandate, the ECB might be reluctant to see those pressures reduced by its own
actions.

I would like to be wrong about this. But if I am not, I think
it is important to understand what it reveals. To quote Peter Dorman: “In their
own minds they probably see neoliberal reforms as self-evidently beneficial to
the point that there is no need to spell them out or argue for them: everyone they know understands that this
has to be the solution.” They are just giving good economic advice, advice that
is needed because politicians too often respond to vested interests rather than
sound economic reasoning.

If this reading is correct, then we have a serious problem. In
this view about what is good economics, Keynes has completely disappeared. Not
only the Keynes who showed why cutting government spending at the ZLB was a
foolish thing to do, but also the Keynes who emphasised that prices in financial
markets may not reflect fundamentals but instead just what market participants
thought that other participants would do.[1] This is the Keynes whose ideas (or
interpretation of those ideas) feature heavily, and very positively, in every
economics textbook, including those used by those teaching in Eurozone
countries. So what remains a real mystery to me is how the elite who make
policy in the Eurozone can feel it is legitimate to promote a view about what
is good economics which contradicts what economists in the Eurozone teach.

For central bankers to give advice on economic issues that are
outside their remit but which pretty well every economist would sign up to is
one thing. Of course central bankers will have their own private views on more
controversial matters. However it seems to me that to give public advice on
economic issues that are outside their remit which are also highly
controversial (and contradict what is in the textbooks) seems to me to be
crossing a line which it is very dangerous to cross.

[1] This is the insight behind the idea, emphasised by De
Grauwe, that there may be a ‘bad equilibrium’ in the market for Eurozone
government debt, which the ECB through OMT can help avoid. (For those
unfamiliar with this idea, a good place to start is this piece by De Grauwe and Li.) It is interesting that the ECB, in justifying OMT, tends to favour the argument
that the market has unjustified fears of Euro break up, rather than that the
market is not looking at fundamentals. It is using an argument that remains
consistent with Ordoliberal ideas.

Monday, 22 July 2013

Central bankers, and even some
of the best economists, sometimes talk about inflation expectations becoming
‘unhinged’. I do not like this term, and have been known to react quite badly
to it. Some might say overreact. Let me say why.

But before doing so, I want to make three things clear, lest I
be misunderstood. First, I think inflation expectations are really important.
Second, I largely believe the great moderation story. As a result of setting
inflation targets (explicitly or implicitly), and acting to achieve them,
central banks did succeed in stabilising inflation expectations at low levels,
and this has made the job of stabilising the economy as a whole rather easier.
I may be wrong about this, but that is what I currently think. (I chose this as an example of the achievements
of the microfoundations revolution in macro in my mild disagreement with Paul
Krugman on this issue.) Third, I think it is more than likely that if inflation
stays above/below target for some time, inflation expectations will
adjust.

But I would not call this expectations becoming unhinged. It is
all about language. I would have no problem if another term was used. I used
the term ‘adjust’ above, but we could also say ‘increase’, or ‘become less
predictable’, or even ‘shift’. In fact any of the other words we normally use
for macroeconomic variables. When discussing consumption, we do not talk about
expectations of future income becoming unhinged. When discussing exchange rates
and UIP, we do not obsess about expectations of future rates being unhinged.
Whether intentional or not, the use of the term unhinged is designed to create
an impression. The impression is of disastrous uncontrollability. If we talked
about a person become unhinged, we indicate madness.

It is as if inflation expectations can be in one of two states:
either low variance with mean reversion to the inflation target (or something
close to it), or as highly volatile and could go anywhere. In this second
imagined state, as expectations of inflation drive actual inflation, we could
have ‘inflation bubbles’, which would become very costly for the central bank
to prick. As we really do not want to go to that second state, we have to do
everything we can to stay in the first state.

It is this view of the world that I find very difficult to
believe - in fact I find it absurd. Why would inflation expectations become so
unanchored from a central bank’s inflation target? They would do so if people
thought the central bank had no intention of trying to achieve that target. So the only circumstances in which inflation
expectations might become unhinged are when the central bank itself became
unhinged. That could happen if the central bank was ordered to permanently
monetise growing budget deficits, but that is not the world we are currently
in.

When central bankers talk about unhinged expectations, they
nearly always mention the 1970s and early 1980s. Do we really want to go through
that again, they ask? Yet that was a period, in the US and UK, when it was very
unclear what the central bank’s inflation target was, or indeed whether it had
one. (This was not the case for Germany, as I note here.) So the lesson of that time is that
inflation targets are important, but not that they should never be changed or
missed.

I would draw a very different lesson from that period. It is
important not to have taboos in macro. If there was a taboo at that time, it
was that rising unemployment would mean a return to the 1930s. This prevented
many seeing variations in unemployment as a means of stabilising inflation.

Could it be that we have a similar problem today, except roles
have become reversed? With nominal rates at the zero lower bound, and doubts
over unconventional monetary policy, we could use higher inflation (raised in a
premeditated and controlled way) as a means of getting unemployment down. Of
course that entails costs, and so we need to do the cost benefit analysis, and
look at alternatives (like fiscal policy) that may be less costly. But if
raising inflation is taboo we will not have that discussion. In this context,
talk of expectations becoming unhinged reinforces that taboo.

In memory of Mel, who showed even as a teenager an appreciation for the absurd by
helping me found the LUWS.

Sunday, 21 July 2013

For those who think I’m exaggerating when I say the
intellectual case for austerity is crumbling, have a look at Alan Taylor’s Vox column. His analysis is particularly nice because it
demonstrates two key problems with some earlier research. If you ignore the
endogeneity of fiscal policy, and you ignore the state of the economy, then his
study (joint with Oscar Jorda) replicates the ‘expansionary austerity’ result.
If you take account of these things, you get numbers much more consistent with,
for example, this widely cited IMF study (although their
analysis attempts to improve on that work). So (journalists please note) it is
not a matter of X says this and Y says something different: if you do the
analysis properly austerity is clearly contractionary in bad economic times.

Alan Taylor also uses his estimates to cost the impact of UK
austerity: GDP would be 3% higher today without it. Here the the relevant chart.

He warns that this number is “likely [to be] a biased underestimate of the effects of
current UK austerity. This caveat is the zero lower bound, when fiscal
multipliers are known to be much larger in both theory and evidence.”
Controlling for booms and slumps makes sense for various reasons, but
controlling for monetary policy is at least as important. That also means that
the 3% should carry the health warning that if UK GDP had been this much
higher, this might have raised inflation, which might have led the MPC to raise interest rates, by more than is implicit in their estimates. But
these are all big ifs.

When I did a back of the envelope calculation of the impact of cuts in just UK
government spending since 2010, I came up with GDP being around 2% lower by
2013. As this ignored the impact of tax increases (e.g. VAT) and transfer cuts,
then this seems quite consistent with Alan Taylor’s 3%. So if we make that 1%,
2% and 3% for 2011, 2012 and 2013, that is a total cost of 6% of GDP so far.
Gross National Income was £1,557,503 million in 2012, and there were 26.4
million households, so that gives gross income of £59,000 per household. So the
6% figure implies that austerity has cost the average UK household a total of
about £3,500 over these three years. Although all governments like to give the
impression that they can have a big impact on people’s prosperity, few actually
do. These numbers suggest that the current UK government has managed to do so, but
unfortunately by making us all poorer.

Friday, 19 July 2013

This post is about the
impact of nominal and real wage flexibility on unemployment and the output gap.
It starts in an academic, abstract sort of way, but the policy implications do
follow. I try and make the analysis as accessible as I can to non-economists.

Start with an economy with a zero output gap (defined below)
and no involuntary unemployment. Everything in the economy is just fine, which
is a non-technical way of saying it is efficient. Then a ‘crisis’ happens that
leads consumers to consume less and save more, so aggregate demand falls.
Normally in these situations the central bank cuts nominal and real interest
rates sufficiently to restore aggregate demand. Once this has happened, call
everything in this economy ‘natural’, so the real interest rate that restores
demand is the natural rate of interest. The natural level of output may not be
the same as the pre-crisis level, because for example the new natural rate of
interest can have knock on effects on how much people want to work. [1] However
the natural level is the level of output that policymakers should aim for. [2]

In the Great Recession this mechanism did not work because
nominal interest rates hit zero, and maybe also because monetary policy put a
cap on inflation expectations. As a result, actual real interest rates are
above the natural level. In addition, fiscal policy is in the hands of people
who know nothing about macroeconomics, so there is no help from there. However
monetary policymakers still think they could do something ‘unconventional’, so
they want to know what to aim for. The answer is that, as long as what they do
does not seriously distort the economy, they should try to get to the natural
level of output, because that produces an efficient economy.

The difference between the actual level of output and the
hypothetical natural level is called the output gap. The traditional way of
defining the output gap was the difference between actual output and
‘productive potential’, which was the amount that could be produced if all
factors of production were fully utilised. That is still how the gap is often measured
in practice, although the measurement problems can still be huge, as Paul
Krugman notes here.
The problem at a conceptual level is that this approach downplays considerations
of optimality, so nowadays theoretical macroeconomics uses the natural level of
output to define the output gap. This has the advantage that we know what
policy should be aiming to do: achieving the natural level of output.

Now imagine three almost identical economies where an output gap
exists because nominal interest rates have hit zero. The level of real interest
rates that would eliminate the output gap is the same in all three economies
(i.e. they have the same natural levels of output). In the first economy,
workers resist nominal wage cuts, so this puts a floor on how much unemployment
reduces real wages. (Equally firms may be reluctant to impose wage cuts, as this research suggests - HT Kevin O’Rourke.)
If nominal wages stop falling, at some point firms will stop cutting prices to
protect their profits. We settle down to a new lower level of demand deficient
output, high unemployment, but stable wages and prices. There is plenty for
unconventional monetary policy to do, even though inflation is not falling.

In the two other economies nominal wages carry on falling. In
the second economy prices get cut pari passu, so real wages remain unchanged,
while in the third they do not, so real wages fall. So in the second economy
inflation is lower than in the first, but real wages are the same. Does this
lower rate of inflation increase or decrease the output gap? That depends only
on whether actual output falls or increases because of lower inflation: the
natural level of output involves a hypothetical economy which is unaffected by
whether nominal wages fall or not in the actual economy [3]. Actual output may
fall if negative inflation makes debtors spend a lot less but creditors not
much more - this and other mechanisms are discussed in Mark Thoma’s post here. However, if monetary policymakers have
been inhibited from doing much because inflation was not falling (which would
be one interpretation of UK policy, for example),
then as David Beckworth says, lower inflation may raise actual output
by encouraging expansionary unconventional monetary policy.

How about the third economy, where real wages have fallen? Suppose
firms respond to lower real wages by substituting labour for capital, and this
process continues until all those who want to work can find a job. So in the
third economy involuntary unemployment goes away. But is the output gap any
lower? Once again, the natural level of output has not changed. (It was set in
our hypothetical economy where real interest rates fell to their natural level.)
So the key question becomes whether lower real wages and lower unemployment
reduces or increases aggregate demand, and therefore actual output. It could go
either way. So it is perfectly possible that both actual output and therefore
the output gap is exactly the same in all
three economies, even though unemployment has returned to its natural rate
in one, and the other two have very different inflation rates.

This comparison suggests that those who say unemployment in the
first two economies is caused by wage inflexibility kind of miss the point. The
basic problem is lack of aggregate demand. You could argue (I would) that the
third economy is better off than the other two, because the pain of deficient
demand is evenly spread (everyone has lower real wages), rather than being
concentrated among the unemployed. But the first best solution is to raise aggregate
demand, because that gets rid of the pain.

I started writing this post because of a recent study by Pessoa and van Reenan, who argue that
the mysterious decline in UK labour productivity that I have talked about before can in large part be explained by
unusually slow growth in UK real wages. The mechanism they have in mind is
entirely traditional: if real wages are low firms substitute labour for
capital. This in turn may explain (see Neil Irwin here
for example) why UK unemployment originally rose by less than in the US (see
first chart), even though the UK’s output performance was worse. On this issue
looking at consumer price based measures of real wages will be misleading, so
below is a very simple measure of real product wage growth in the two
countries: compensation per employee less the GDP deflator. Real wage growth in
the UK has noticeably fallen since the recession, whereas the fall has at least
been less abrupt in the US (2013 is a forecast).

In terms of just the UK economy, whether Pessoa and van Reenan
are right is debatable. When I discussed this in an earlier post I referenced a
Bank of England paper by MPC member Ben Broadbent, which
argued that for the factor substitution story to explain most of what we have
seen in the UK, investment should have completely collapsed, which it has not.
This difference in view reflects a number of nitty gritty issues, like how you
measure the capital stock, and whether the substitution elasticity is one (as
implied by the Cobb Douglas production function), or nearer one half.

However most seem to agree that some of this factor substitution is going on in the UK. So my
hypothetical discussion above suggests that, by spreading the pain of deficient
aggregate demand further, this ‘real wage flexibility’ in the UK has been a
good thing, but it does not mean the aggregate demand problem has decreased. If
anything, it suggests that looking at unemployment underestimates the size of the output gap. Monetary policy makers
please note.

[1] New Keynesian economists sometimes call the natural economy
the outcome when all prices are completely flexible. That is OK, as long as we
note that flexible prices here has to include the possibility that nominal
interest rate can go negative, which in the real world it cannot.

[2] Opinions may differ on whether the crisis itself is a
necessary correction for past errors, or whether it is itself a distortion. For
example, was risk undervalued before the crisis, or is it overvalued now. In
other words, was the pre-crisis economy efficient, or would there be a
distortion in the post-crisis economy even without an aggregate demand problem?
These are important complications compared to the story I tell here, but they will have to wait for another post.

[3] The idea is that the economies are identical except for the extent of nominal inertia in goods and labour markets. In economy 1 wages are sticky, in economy 3 prices are sticky but wages are flexible, and in economy 2 the degree of wage and price stickiness is such that real wages do not change.

Thursday, 18 July 2013

It really was predictable. Take away the ability to control
national interest rates, and you create a potential for patterns of demand to
diverge, leading to movements in competitiveness that would have to be
painfully unwound later on. The good news was that you could use
countercyclical fiscal policy to moderate these movements - an entirely
conventional macroeconomic idea. But it was not what the architects of the Euro
wanted to hear.

This is how my paper just published in Global Policy starts.
So instead of countercyclical fiscal policy, we got an obsession with budget
deficits and the possibility of fiscally profligate governments. Even with this
obsession the Eurozone failed to spot its one member that was behaving in this
way until it was too late. But in looking in the wrong direction, the Eurozone
allowed just the kind of competitiveness imbalances to take place that fiscal
policy might have been able to do something about.

This is not wisdom from hindsight. Before the Euro was
established, I was among a large group of economists suggesting that fiscal
policy should be used countercyclically by Eurozone members. That work
continued after the Euro was established: here and here are just two examples. It had no impact
on policy. There was a lot we did not foresee. It is particularly ironic that
the first major asymmetric shock to hit the Euro area, that would cause these
large competitiveness imbalances, was arguably a consequence of the creation of the
Euro itself. But the point remains that a method of handling these things,
which was entirely conventional in macroeconomic terms, existed and was
ignored.

Now in saying this I find myself in the rather unusual position
of disagreeing with Martin Wolf. He has argued (here for example) that a country like Spain
could not have done more in terms of fiscal policy to counteract its housing
boom. I have heard many others make the same point - you think Spain should
have been running even larger surpluses? they ask incredulously. The answer is
simply yes: by looking at fiscal surpluses you are looking at the wrong
indicator. Here is what happened to consumer price inflation from 2000 to 2007.

2000

2001

2002

2003

2004

2005

2006

2007

Ireland

5.3

4.0

4.7

4.0

2.3

2.2

2.7

2.9

Spain

3.5

2.8

3.6

3.1

3.1

3.4

3.6

2.8

Portugal

2.8

4.4

3.7

3.3

2.5

2.1

3.0

2.4

Euro area average

2.2

2.4

2.3

2.1

2.2

2.2

2.2

2.1

Inflation was significantly above the Euro area average year
after year. If the average inflation rate had been 10%, or even 5%, this might
not have been a big deal, but when the inflation target was 2% or less, that
makes reversing these trends very painful. Looking at budget surpluses during a
property led domestic boom can be very misleading, as Karl Whelan argues in the case of Ireland.

There may be many reasons why the Eurozone ignored this advice.
One was probably a belief among some that countercyclical fiscal policy was
either ineffective or dangerous. (The ordoliberal logic on this has never really
been spelt out, and it seems more like an article of faith.) Another was an
almost mystical belief that the creation of the Euro would diminish the
importance of asymmetric shocks or the extent of asymmetric structures.[1] Yet
another was a view that the far greater danger lay in the reduced fiscal
discipline that being part of the Euro would bring, and any countercyclical
role would only encourage this ill discipline. Yet we now know (and I do not
think anyone really foresaw this) that this last argument is completely wrong.
Not having your own central bank means that market discipline on Euro members’
fiscal policy will be much greater, once it is understood that national default
can occur.

I do not think this point has sunk in yet among many
macroeconomists. The standard line, backed by academic papers, was that joining
a common currency would reduce market discipline on fiscal policy. Yet that
analysis ignored default, and the possibility of a bad equilibria generating a
self-fulfilling crisis. Countries will not forget the events of 2010-12 in a
hurry, so the danger now is that we have too much, not too little, market
discipline influencing fiscal policy.

Ironically, the architecture of the Stability and Growth Pact
sent all the wrong signals. By stressing the dangers that individual countries
might free ride on the Eurozone, it suggested that such actions might be in the
national interest for any country that could get away with it. That is why attempts
to control national budgets at the Eurozone level can be counterproductive as
well as unnecessary. It is far better to build national institutions that can make sure countries develop
appropriate fiscal policy which is in their national interest. In an ideal
world the Commission might play a coordinating role, but given its current
mindset it would be best if it just stayed out of the picture.

So while the details of the Euro crisis were not foreseen, the
palliative medicine that would have made that crisis much more manageable was
available, but those in charge decided not to take it. What turns this serious
policy error into a tragedy is that policy makers continue to make the same
mistake. The Fiscal Compact is exactly
the opposite of what the Eurozone requires right now. (I have cited the Netherlands as a clear example of this.)

This makes me both optimistic and pessimistic about
macroeconomics as a discipline. Optimistic because the subject has so much
potential to do good: basic ideas, long understood, yet clearly not obvious to
some, can help prevent disaster. (Those who claim that macroeconomics is the
weak point of the economics family should take note.) Pessimistic because even
when those disasters occur, the macroeconomic wisdom continues to be
ignored.

[1] If anything, formation of a currency union should allows
greater national specialisation, which of course has the opposite effect.

Wednesday, 17 July 2013

Tony Yates thinks there should be no more [sic] fiscal
stimulus in the UK, because inflation is above target. As inflation is above
target, there is no need to stimulate demand. Tony accepts that in principle at
the ZLB fiscal stimulus can be a useful expansionary instrument, but in the UK
at the moment it is not required.

So here is a table of CPI inflation in a few countries.

CPI Inflation rates (source: OECD Economic Outlook)

2007

2008

2009

2010

2011

2012

2013

2014

United Kingdom

2.3

3.6

2.2

3.3

4.5

2.8

2.8

2.4

United States

2.9

3.8

-0.3

1.6

3.1

2.1

1.6

1.9

Euro area

2.1

3.3

0.3

1.6

2.7

2.5

1.5

1.2

The inflation target in the UK is 2%. So not only is there no
case for any stimulus going forward, it also looks like the UK managed to
completely avoid any recession in 2008/9! The US also had a small boom in 2011,
and who knows why people in the Eurozone feel so depressed?

OK, this is a cheap point, but a valid one nevertheless: CPI
inflation is a pretty hopeless indicator of the output gap when inflation is
low. Other inflation measures do a bit better: here is the GDP deflator at
basic prices.

UK Inflation: source ONS

Some of the low growth in the GDP deflator is because of low
inflation in the government consumption deflator, and we know this is difficult
to measure. However I’m not trying to argue that one index is better than
another. Instead I just want to make the point that at low levels of inflation,
inflation itself becomes a very unreliable measure of the output gap. This is
true not just in the UK, as the IMF recently pointed out.

One reason why UK inflation has not fallen further is UK labour
productivity, which I have discussed before. Now if the decline in UK productivity
growth was an irreversible supply side phenomenon then you could indeed argue
that the current UK output gap was small (but not zero - see below), but is
this remotely plausible?

Here is a chart of (logged) UK GDP since 1950. [1] I’ve added a
trend line not because I believe productivity growth is always constant, but
just so the following point becomes clearer. GDP growth does sometimes fall
sharply: in 1980, and in 1990. But both these occasions were demand induced
recessions. To argue that 2008/9 is different means that something quite extraordinary
and unprecedented has happened. Now maybe that is possible, but given the costs of being wrong about this, we have to be
pretty certain of your story to base policy on it.

UK GDP, logged. Source - see [1]

So let us look at something we can measure with reasonable
accuracy: unemployment.

UK Unemployment Rate: ONS

The increase in unemployment since 2008/9 is modest given the
output fall - productivity again - but it is not small. I have heard no one
argue that this increase in unemployment represents an increase in the NAIRU or
natural rate. To the extent that low real wage growth has encouraged
substitution from capital to labour, unemployment underestimates the extent of
the output gap. (If unemployment continues to fall at the same rate it has over
the last year - a rate the Employment Minister describes
as encouraging - we should see a return to pre-recession levels sometime after
2025.)

So it seems to me that we are sitting in a freezing house, but
because the thermostat says it is still warm, its occupants are trying to
convince themselves that they are not really feeling cold, and the last thing
they want to do is turn up the heat. (I admit not the best of analogies for the
UK right
now.) Just because we build models in which inflation always
responds in a predictable and linear way to the output gap, does not mean that
the real world behaves in the same way.

[1] I’ve spliced the recent ONS data revision from 1998 on to a
time series from Lawrence H. Officer and Samuel H.
Williamson, 'What Was the U.K. GDP Then?' MeasuringWorth, 2012.

Tuesday, 16 July 2013

In an earlier post
I went through the logic of why we do not think higher government debt necessarily
causes inflation, even if that debt is denominated in nominal terms, as long as
the central bank does not monetise that debt. As I argued there, talk of
monetisation is largely unnecessary: we just need to say that the central bank
uses interest rates to control inflation, and can therefore offset the impact
of any increase in government debt.

However, as Mervyn King said,
central banks are obsessed with budget deficits. This seems to contradict the
previous paragraph. Are there some ways in which central banks would either
lose the power to control interest rates, or be forced to abandon any inflation
targets, as a result of fiscal policy?

In the previous post the thought experiment I considered was a
sustainable increase in the level of government debt. By sustainable I mean
that the fiscal authorities raise taxes (or cut spending) to service this
higher level of debt. But suppose they do not: suppose the budget deficit
increases because spending is higher, but there is no sign that the government
is prepared either to cut future spending or raise taxes to a sustainable
level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the
central bank could in the short term control inflation, but in the longer term
inflation would have to rise to create the seignorage to make the government
budget constraint balance. In other words, to keep the economy stable the
central bank would eventually be forced to monetise. This was later generalised
by the Fiscal Theory of the Price Level (FTPL). If the government did not act to
stabilise debt itself (which Eric Leeper called –
a little oddly - an active fiscal policy, and which others - including
Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian
policy [1]), then the price level would adjust to reduce the real value of government
debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government
budget constraint appears not to hold at disequilibrium prices. See, for
example, Buiter here, and a response from Cochrane. I do not want to go
into that now. Let’s also concede that if the monetary authority does either follow
a rule that allows the price level to rise (by fixing the nominal interest rate
for example), or tries to move interest rates to both stabilise debt and
inflation (as in my recent paper
with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank
refuses to do either of those things, but carries on controlling inflation and
ignoring debt. Suppose the government is running a deficit which is only
sustainable if we have a burst of inflation which devalues the existing stock
of government debt, but the central bank refuses to allow inflation to rise.
You can say it does this by fixing the stock of money, or by raising the rate
of interest - I do not think it matters which. This is an unstable situation:
interest payments on the stock of debt at the low price level can only be paid
for by issuing more debt, so debt explodes. In this situation, we have a game
of chicken between the government and central bank.

Now the game of chicken would probably end when the markets
refused to buy the government’s debt. That would be the crunch moment: either
the central bank would bail the government out by printing money, or the
government would default, which forces it to change fiscal policy. But in Buiter there is an elegant
equilibrium outcome: the market just discounts the value of debt by an amount
that allows the central bank to set the price level, but for the government’s
budget constraint to hold at that price level. We get partial default. This
discount factor becomes the extra variable that solves for the tension that
both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank
could not exist, because the government has ultimate power. It can always
instruct the central bank to monetise the debt. However suppose the central
bank actually managed the currency for a whole group of nations, and could only
be instructed to do anything if they all agreed to do so. Furthermore that
central bank was located in the one country in that group that would never
contemplate monetisation, so it would be immune to pressure ‘from the street’.
That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It
seems to me pretty clear that these governments are not playing any game of
chicken. Quite the opposite in fact: they are being far too enthusiastic in
doing what they can to stabilise debt, despite there being a recession. So we
certainly do not seem to be in a FTPL type world. Instead monetary policy right
now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather
than trying to convince central banks that their fears are groundless, we
should be asking whether monetary policy should – of its own free will – raise
inflation to help reduce high levels of debt. I agree with Ken
Rogoff that it should, and have argued the case here.
Yet however optimal such a policy might be, the chances of it happening in
today’s environment are nil. It looks like we may have to go through a lost decade
before we are allowed to contemplate such things.

[1] I guess a rationale for calling this fiscal policy ‘active’
is that stable regimes in Leeper require one partner to be active and the other
passive. So in the normal regime monetary policy is active and fiscal passive,
and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no
longer holds (because taxes are not raised following a tax cut) – hence the
label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show
weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as
default free debt issued by the central bank rather than money, then not at all.
Instead the central bank is giving the fiscal authority the best chance it can
to put its house in order, by removing any bad equilibrium, but it retains the
power to force default at any point. We no longer have Buiter’s method of
resolving that game, but only because the central bank has the means which
could force a win. As long as the government believes that the central bank
would prefer the government to default rather than see inflation rise, the
government should back down.